Average incremental cost pricing in electricity auctions

Wholesale electricity markets are typically organized as uniform-price auctions with non-convex bids. The main implication of these non-convexities is that they impede the existence of “market-clearing” prices. Several pricing mechanisms that deal with this issue have emerged from the literature. We analyze Average Incremental Cost (AIC) pricing. The underlying idea of AIC pricing is to price at the “average incremental cost” in order to eliminate the need for discriminatory make-whole payments. We formalize this notion and study its consequences for market participants. We show that AIC pricing eliminates make-whole payments for suppliers with the possibility of inaction in a one-sided auction. Regarding the network, we show that AIC prices guarantee that there is no price arbitrage opportunity in the network. Inflating the price to eliminate make-whole payments can however worsen the incentives of market participants, thus creating the risk of exacerbating self-scheduling behavior. Our analysis also provides a comparison of AIC pricing with marginal pricing, convex hull pricing and another approach that eliminates make-whole payments. Such a comparison is critical for correctly appreciating the relative merits and drawbacks of AIC pricing.